'There are quality funds out there at attractive discounts'

With the average investment trust returning 165 per cent over the past five years, compared with a still healthy 89 per cent for its unit trust counterparts, you could be forgiven for wondering why they aren't more popular among private investors.

One of the reasons why performance has been so superior is that investment trusts are more likely to invest in volatile sectors such as emerging markets, which have performed spectacularly well recently. But comparing apples with apples — by looking at investment trusts and unit trusts run by the same fund manager that run almost identical portfolios — shows that investment trusts have still produced better returns.

For example, Standard Life's UK Smaller Companies unit trust, run by Harry Nimmo, has returned 195 per cent in the past five years. Not bad, you might think, but not as good as the 262 per cent from the Standard Life UK Smaller Companies Trust. The outperformance is because investment trusts can "gear" – in other words, borrow money to buy shares. When markets go up this can boost returns, although if they make a wrong call, any losses will be accentuated.

Annabel Brodie Smith at the Association of Investment Companies, says that another the reason why investment trusts have performed so much better is the fact that their charges are generally lower. Figures from the Association of Investment Companies (AIC) show that for large funds (those which have more than £500m of assets), the average annual reduction in the investor's return caused by the fund manager's charges is as low as 0.78 per cent, compared with 1.37 per cent for unit trusts.

Over time, that extra expense will make a considerable dent in your return. Over 10 years on a £10,000 investment, assuming a return of 7 per cent a year, it is the difference between a final fund value of £18,283 and £17,223. But there are still some expensive investment trusts out there, so do your homework before putting your money in.

"Unit trusts in general pay 3 per cent upfront commission to financial advisers and 0.5 per cent a year thereafter, whereas investment trusts do not pay any," says Nick Sketch, divisional director at Rensburg Sheppard, an adviser.

Sketch believes another reason for their improved performance is the fact that they are better suited to certain market situations because the fund manager has a fixed amount of money. Investors buy shares in the investment trust, the price of which go up or down, whereas with unit trusts, new money from investors goes into the fund manager's account and he or she has to find a place to invest it.

Sketch says: "If you are running a £300m investment in India, you know exactly what you have to play with. If you run a unit trust and you find that you have a large amount of new money coming into a fund, then you have to find something to invest it in, and that may prove problematic."

That said, even supporters of investment trusts say both types of investment asset have roles to play in an ideal portfolio. "It shouldn't be a case of do I go for an investment trust or a unit trust. Both have a place in a portfolio, but there are specialist areas that you can get into with investment trusts, such as splits," says Gavin Haynes of Whitechurch Securities.

The split-cap debacle at the beginning of the decade attracted a lot of negative publicity for investment trusts when some investment trust companies employing excessive gearing and cross-­holdings between different trusts left investors seriously out of pocket after markets nosedived. The collapse of splits prompted an investigation by the City regulator and compensation from providers.

But zero-dividend preference shares, the share class at the heart of the scandal, could be set for a rehabilitation, says Haynes, thanks to changes in capital gains tax coming in next year.

At present, CGT is paid at whatever rate you pay income tax, but from April, the CGT rate will be reduced to 18 per cent across the board. ­"Higher-rate taxpayers will be better off receiving profits from their investments in a way that attracts CGT than through income. Zeros allow you to take no dividend income at all, and receive all your upside as a capital gain, so there could be a new advantage for splits next year," says Haynes, although he warns investors to seek expert guidance.

Many investment trusts also trade at a discount when supply outstrips demand. This means that because market sentiment has gone against a sector, then its shares go down in relation to the value of the underlying assets. This means that it is possible to buy shares worth £1 for 90p.

But of course there is no such thing as a free lunch and until and unless market sentiment on that sector changes, you will only be able to sell them for 90p. This adds to the volatility of investment trusts over unit trusts which have transparent pricing of assets. There also may be good reason why a trust is trading on a discount – it is a bad performer and investors want out.

The effect of market sentiment on investment trusts today is not surprisingly most evident in the troubled property sector. Commercial property investment trusts are currently trading at a discount of 32 per cent, which means that for £100 you can buy assets that are valued at £147.

The reason for this disparity is that market appetite for commercial property is weak — and so you could argue that this means the assets are only worth £100 after all.

But one advantage of investment trusts is that you are buying at a price that reflects the market's view of those assets. Buying exposure to commercial property through a unit trust will see you paying the full £147 for the same assets that are being sold for £100 in the investment trust.

"Anyone going out now to buy a unit trust fund manager's commercial property fund today needs their head examining when they can get the same assets on a 32 per cent discount through an investment trust," says Sketch. "There are quality funds out there at attractive discounts right now."

One of Sketch's favourite unit trusts is the F&C commercial property trust. "It has a good portfolio of £1.2bn-worth of top value property and a net yield of 6.4 per cent. It is only geared to 15 per cent of the portfolio's value so it is low risk in that regard, and it is currently trading at a 32 per cent discount because the market clearly believes the assets are overvalued. If I take that income and then in 10 years, commercial property is back in favour, not only will the share price have gone up but the margin will have narrowed, presenting me with significant upside."

"I am buying it for the diversification that it brings to my portfolio. Commercial property tends to move in a different direction to equity markets and that can give your portfolio some useful diversity," says Sketch.

Investment trusts can also give you access to some of the most sought-after fund management on the market. Mark Dampier of Hargreaves Lansdown likes the RIT Capital Partners trust, which invests in a range of assets. He says: "This fund gives you access to hedge fund management and private equity. You are putting your money along side the Rothschilds, so you are getting access to some of the best deals there are."